Red Hat's Valuation Looks More Reasonable, But Expectations Could Be Problematic

There's room for more than one successful model in the software world, and not every company has to be IBM (NYSE:IBM) or Oracle (Nasdaq:ORCL). To that end, cloud-based models like Salesforce.com (NYSE:CRM) and service/support-oriented models like Red Hat (NYSE:RHT) can work in terms of generating attractive revenue and free cash flow growth rates. What's key, though, is understanding what's different about these models and adjusting expectations accordingly, and that may still be a significant source of risk to Red Hat investors.

Fiscal Q4 Numbers Came In Weaker Than Expected
Like Oracle and TIBCO (Nasdaq:TIBX) before it, Red Hat delivered a relatively disappointing quarterly result, though the magnitude of the disappoint was different. Even so, investors may do well to take a more cautious view of underlying growth here.

Reported revenue rose 18% on a constant currency basis, with sequential growth of 1%. Subscription revenue rose 20% and 3%, respectively, while service revenue rose 8% and fell 9%. More worryingly, billings were up only about 9%, well below the low-to-mid teens expectation of the Street against a difficult +31% comp from last year.

Once again, margin leverage was nowhere to be seen. Gross margin on a GAAP basis declined about half a point. Non-GAAP operating income rose 8%, with the margin falling two points, but did at least keep pace with revenue on a sequential basis.

It's also worth noting that not all analysts view Red Hat's underlying growth in the same way. In particular, JPMorgan's analyst John DiFucci uses an adjusted billings calculation that attempts to factor in the impact of currency, contract duration, and renewals. By this methodology (which is not endorsed by the company, nor used by any other analysts to my knowledge), underlying new business may have actually declined 14% for the quarter and barely grew at all for the fiscal year. While I'm not personally advocating or vouching for this methodology, I believe investors do well to consider both bullish and bearish arguments when evaluating a company/stock.

No Leverage = No Problem?
I've complained before that this newer generation of software companies like Red Hat, TIBCO, VMware (NYSE:VMW), and Salesforce.com don't deliver the same sort of operating leverage we saw before with companies like Oracle and Microsoft (Nasdaq:MSFT). That's not a bad thing per se; it's just a different model. Nevertheless, I wonder about the extent to which investors appreciate this, as it seems like many analysts just blithely assume operating leverage will materialize in the future.

I think it's also important to understand why Red Hat may never generate substantial operating leverage. Here again, I have to acknowledge the work of Mr. DiFucci, as he has written extensively on this topic.

Remember that Red Hat doesn't sell software per se – its products are open source and can be downloaded and used by anybody at no charge. What companies pay for is the support and service subscriptions. Most software companies do not pay sales commissions for subscription renewals (which is part of the ServiceSource (Nasdaq:SREV) business model, by the way), but Red Hat does. That leads to relatively high sales and marketing spending as a percentage of sales, and this will likely always be the case – if Red Hat stops paying commissions on those renewals, the sales force won't focus on them, and clients will leave for rivals willing to offer service/support at lower prices (which includes established rivals like Oracle). None of this makes the Red Hat model “bad” or “wrong”, just different, and it's important to understand the ramifications of those differences.

The Bottom Line
While I do have my concerns about the underlying pace of new business growth at Red Hat, as well as an overall weakening software environment, I think Red Hat can continue to post solid top-line growth. There is still the opportunity to leverage the conversion of Unix to Linux (Unix share is more than double Linux share today, and Red Hat has roughly 60% share of the Linux market), and I wouldn't assume that Microsoft's Windows server business is impregnable. Likewise, I think JBoss is a competitive product to IBM WebSphere and Oracle WebLogic, and that storage and cloud products offer some long-term upside.

I also think that expectations are getting more reasonable on these shares. I do believe that Red Hat can deliver low double-digit long-term revenue growth, with slightly higher free cash flow growth. That low teens growth assumption leads to a fair value in the low $50s, which puts this stock in an interesting position – while approximately 10% undervaluation may not sound like much, remember that the underlying growth rate here is still likely to be strong. That means Red Hat could be a market-beating stock from these levels if the revenue/cash flow growth trajectory stays strong.

Even so, beware of runaway expectations if and when sentiment picks up again. While Red Hat has a pretty good business and a workable model, it's a non-traditional model and investors need to always keep that in mind.

At the time of writing, Stephen D. Simpson owns shares of EMC, which owns a majority of VMware.